Monopolistic Competition Economics 101

Definition Monopolistic Competition Many firms selling products that are similar but not identical. Markets that have some features of competition and some features of monopoly.

Attributes Attributes of Monopolistic Competition Many sellers Product differentiation Free entry and exit

Attribute 1 Many Sellers There are many firms competing for the same group of customers. Product examples include books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc.

Attribute 2 Product Differentiation Each firm produces a product that is at least slightly different from those of other firms. Rather than being a price taker, each firm faces a downward-sloping demand curve.

Attribute 3 Free Entry or Exit Firms can enter or exit the market without restriction. The number of firms in the market adjusts until economic profits are zero.

Short-Run Economic Profits The Monopolistically Competitive Firm in the Short Run Short-run economic profits encourage new firms to enter the market. This: Increases the number of products offered. Reduces demand faced by firms already in the market. Incumbent firms’ demand curves shift to the left. Demand for the incumbent firms’ products fall, and their profits decline.

(a) Firm Makes Profit Price MC ATC Demand MR Profit- maximizing quantity Price Average total cost Profit Quantity Copyright©2003 Southwestern/Thomson Learning

Short-Run Economic Losses The Monopolistically Competitive Firm in the Short Run Short-run economic losses encourage firms to exit the market. This: Decreases the number of products offered. Increases demand faced by the remaining firms. Shifts the remaining firms’ demand curves to the right. Increases the remaining firms’ profits.

(b) Firm Makes Losses Price MC ATC Losses Loss- minimizing quantity Average total cost Demand Price MR Quantity Copyright©2003 Southwestern/Thomson Learning

Long-Run Equilibrium Firms will enter and exit until the firms are making exactly zero economic profits.

Price MC ATC Demand MR Profit-maximizing quantity P = ATC Quantity Quantity Copyright©2003 Southwestern/Thomson Learning

Characteristics of Long-Run Equilibrium Two Characteristics As in a monopoly, price exceeds marginal cost. Profit maximization requires marginal revenue to equal marginal cost. The downward-sloping demand curve makes marginal revenue less than price. As in a competitive market, price equals average total cost. Free entry and exit drive economic profit to zero.

Monopolistic versus Perfect Competition There are two noteworthy differences between monopolistic and perfect competition—excess capacity and markup.

Excess Capacity Excess Capacity There is no excess capacity in perfect competition in the long run. Free entry results in competitive firms producing at the point where average total cost is minimized, which is the efficient scale of the firm. There is excess capacity in monopolistic competition in the long run. In monopolistic competition, output is less than the efficient scale of perfect competition.

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Price Price MC ATC MC ATC Demand MR P Quantity produced Efficient scale P = MC MR (demand curve) Quantity produced = Efficient scale Quantity Quantity Copyright©2003 Southwestern/Thomson Learning

Markup Markup Over Marginal Cost For a competitive firm, price equals marginal cost. For a monopolistically competitive firm, price exceeds marginal cost. Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically competitive firm.

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Price Price MC ATC MC ATC Markup Demand MR P Quantity produced P = MC MR (demand curve) Quantity produced Marginal cost Quantity Quantity Copyright©2003 Southwestern/Thomson Learning

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Price Price MC ATC MC ATC Markup Demand MR P Quantity produced Efficient scale P = MC MR (demand curve) Quantity produced = Efficient scale Marginal cost Quantity Quantity Excess capacity Copyright©2003 Southwestern/Thomson Learning

Monopolistic Competition and Welfare of Society Monopolistic competition does not have all the desirable properties of perfect competition. There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost.

Monopolistic Competition and Welfare of Society However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming. Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the “ideal” one. There may be too much or too little entry.